Pages

Monday, June 3, 2013

Can a Raise be Bad for Your Finances?

A heuristic I’ve heard about a few times is that you should have 12 times your gross salary saved before you retire. I’ve always had a vague feeling of uneasiness about this rule of thumb, but the problem with it never hit home with me until I started thinking about a raise I’m expecting soon.

Suppose I currently have retirement savings equal to 11 times my salary. I’m close to being able to retire by the 12 times salary heuristic. Suddenly, through no fault of my own, I get a 10% raise. Now my retirement savings are only 10 times my salary. My retirement dream is slipping away. I probably have to work an extra year or two and pray I don’t get any more raises.

This is crazy. The ratio of savings to salary just makes no sense for me. I should be calculating the ratio of my savings to my yearly spending instead. Focusing on this spending-based ratio means that raises are a good thing because they allow me to build my savings faster.

It may be that the savings to salary ratio makes sense for people who automatically increase their spending to match any pay increases, but that doesn’t apply to my family. My raises have no noticeable effect on my family’s spending. I’m going to delete the cell in my savings spreadsheet that calculates my savings to salary ratio.

The trouble you have encountered resulted from the truncation of a valid rule to a "rule of thumb" format. The full rule, though I do not subscribe to it, should have sounded something like: if you spend all you earn and in retirement expect to leave the same life as you do now and your life expectancy is average, you shall need 12x your annual income to retire at average retirement age. But this is too many ifs for a regular Joe coming to a broker to park his savings. Assessing these ifs takes too much effort for both Joe and broker. Besides, it might get Joe thinking and perhaps asking advice from an independent party, which broker does not need.

@Potato: I suppose you could use gross salary less contributions to savings as an approximation of spending.

@Big Cajun Man: I would have thought that almost all raises for government employees were independent of performance :-)

@AnatoliN: I think the actual assumption is that you spend some fixed fraction of your salary like 80% or 90%. However, the critical thing for this rule of thumb to make any sense is that your spending always scales with your income. This may make sense for people at least 15 or 20 years from retirement, but I would hope that those approaching retirement (and concerned about it) would save more when getting a pay increase rather than increase their spending.

I never really did satisfy myself with a resolution to the paradox. I think it has to do with the fact that I'm assuming a particular value is constant (time until retirement) in a calculation that affects that value. A more extreme example might be "since I'll have a million dollars when I retire, and that's enough for me, I might as well donate all my money to charity".

The "bad" approach is to keep your savings constant and spend the raise, so you quickly fall behind. The "ok" approach is to keep the same ratio of saving and spending after the raise, which works on a monthly basis but means you have longer to go because you haven't been earning that salary for your whole career. The best approach is to keep your spending constant and increase your savings. Generally I would expect anything but the bad approach to work out in the end.

I measure the amount we save every month as a percentage of income because that creates a minimum target for any additional income (although I prefer to invest all additional income). However the end goal is based only on expenses which are usually steady or slowly declining regardless of our income. I even have a chart that shows our potential monthly investment income compared to our expenses.

I hadn't heard that rule. It sure doesn't apply if you earn a high income and don't spend much of it. And even more so if you spend half or more of what you do spend on feeding, clothing, training and entertaining your children, unless unfortunately your children have issues that will preclude them ever becoming independent.

Maybe this explains, though, why so many people with 1.5-2.5 million in the bank write to newspaper financial advice columns asking if they can afford to retire. Someone has sold them on this largely unrealistic need for a massive capital pool to draw on in retirement.

I wonder what would make a good rule of thumb, though? Maybe some multiple of your annual spending not including any spending for children who will be independent at retirement?

@Bet Crooks: When you're still decades away from retirement, I think it's difficult to predict what you're spending will look like when you're much older. A better rule of thumb for the young is one based on saving. If you can use your full RRSP and TFSA room each year and you don't do anything too foolish with your investment choices, you're well on track. As you get closer to retiring, a heuristic based on some multiple of your yearly spending makes sense.